First-Time Buyer: What Happens When Interest Rates Rise?
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First-Time Buyer: What Happens When Interest Rates Rise? (Part 1)
What does it mean when interest rates rise?
When interest rates rise, borrowing becomes more expensive across the board. The phrase normally refers to one of two things: the Bank of England’s base rate (also known as the ‘bank rate’), which is what the Bank charges commercial banks to borrow money overnight, or mortgage rates rising, where your monthly payment is likely to increase because the cost of borrowing has risen. The base rate acts as the foundation for almost every other interest rate in the UK economy.
There are multiple factors behind why rates go up. The Bank of England base rate sometimes increases because inflation is too high and the Bank is worried about prices running away from wages. Raising the base rate slows down borrowing and reduces the rate of price increases.
How do people predict interest rate rises?
Predictions of mortgage interest rate rises are normally based on something called SONIA swaps. SONIA stands for Sterling Overnight Index Average and is the benchmark the Bank of England uses, having replaced LIBOR after the global financial crisis as the measure on which banks lend money to one another overnight.
A SONIA swap rate is effectively a prediction of where the base rate will be, on average, over a specific time horizon. You can get SONIA swap rates over one, two, three, five, seven, 10, 15, and 20 year periods. So the two year SONIA swap suggests what money markets expect the average base rate to be over the next two years.
Banks and building societies use SONIA swaps as the benchmark for fixed-rate mortgages. They take the swap rate over a particular time horizon and add on a profit margin. That gives the actual fixed rate you see on a mortgage interest rate table.
Why do rates change?
Rates change because of something happening within the economy, and usually that something is inflation. There are two types of inflation, and they tell you very different stories.
Demand-pull inflation isn’t particularly bad. It means the economy is growing: people have more money in their pockets and are spending. When more people are spending, the cost of goods rises because there’s a finite supply. Prices rise, and the Bank of England raises interest rates because the economy is healthy and booming.
What we’ve seen more recently has all been cost-push inflation, which is bad. That’s where the cost of producing goods increases. If the cost of energy goes up, because energy is an input to everything, the cost of goods rises. That pushes up the inflation rate. It’s bad because it’s caused by a negative shock to the economy.
The only lever the Bank of England has is to increase the base rate to stop people spending and therefore control inflation. That’s ultimately why interest rates rise, and how everything interlinks.
Do first-time buyers get worse interest rates?
No, but this is a very common misconception. First-time buyers aren’t treated differently from other borrowers when it comes to interest rates. It’s not like passing your driving test, where insurers don’t know if you’re a safe driver and give you a higher premium. That’s not how mortgages work.
First-time buyers do often end up paying higher interest rates, but not because they are purchasing for the first time. It’s typically because they have smaller deposits. The deposit is the biggest factor in the interest rate you’ll get, and most first-time buyers have a low deposit of 5% or 10%.
There are other factors too. Sometimes mortgage lenders are actively chasing people who want to remortgage or move home, so they price their products to attract that type of business. That lender then doesn’t have great first-time buyer rates, but it’s not because they don’t like first-time buyers. They’ve just got enough of that business on their books and they’re after a different part of the market.
Who decides interest rates? How often do they change?
The ultimate driver of interest rates in the UK economy is the Bank of England. The base rate is set by the Bank’s Monetary Policy Committee, which meets eight times a year (roughly every six weeks) and gives its decision the same day.
The committee is made up of nine members: the Governor of the Bank of England, three Deputy Governors, a Chief Economist, and four external members appointed by the Chancellor of the Exchequer. The external members are lay members, but they tend to be prestigious economists.
At each meeting they discuss where the economy has been, where it’s going, and how to balance all the risks it’s facing, both immediately and into the future. They then take a vote. How that vote splits is published in the minutes. Nine votes are cast, and if five people vote to keep interest rates the same and four vote to decrease them, the interest rate stays the same. It’s a democracy.
They’re continually looking at data on the UK economy and how it might impact economic growth, unemployment, the property market, employers, and business investment, then adjust the interest rate accordingly.
The minutes of each meeting can tell us where they think interest rates are going, and that in turn moves mortgage rates and swap rates because it sets an expectation. If the minutes suggest the committee thinks unemployment is going to rise, money markets will almost certainly assume the Bank will reduce interest rates. SONIA swap rates fall, and after a lag, mortgage interest rates fall.
The opposite can also happen. If the economy is booming, GDP is growing, and we’re approaching full employment, there aren’t enough people to hire and wages get pushed up. The committee might think the economy is running a bit too hot, which suggests the base rate will increase. In that case, SONIA swaps go up, and so do mortgage rates.
How quickly do rate increases affect mortgage rates?
How quickly a base rate change affects your mortgage depends on the type of mortgage you have. With a tracker mortgage, which directly tracks the Bank of England base rate, your payments typically change the next month. When the rate changes, whether up or down, you receive a letter from your lender stating how much your interest rate is changing by and the date the new rate starts.
Variable mortgages work differently. Each lender has a ‘standard variable rate’, which is their internal profitable rate, and it’s what people roll on to after a specific deal expires. Some banks and building societies move their standard variable rate in line with the Bank of England base rate, but they’re not mandated to. The base rate can change without your lender changing its own rate, or your lender’s rate can change without the base rate moving.
Most people, and particularly first-time buyers, look at fixed-rate mortgages because they like the stability of knowing the mortgage payment isn’t going to change. Fixed rates are typically priced against the SONIA swap and are influenced by expectations of where the bank rate is going. They are not directly correlated with the base rate. So if the Bank of England decreases interest rates, it doesn’t necessarily mean fixed-rate mortgage pricing comes down. And if you’re already in a fixed-rate mortgage, your monthly payment doesn’t change either way. That’s the point. You keep the same interest rate for two, three, five, or ten years depending on how long you fix for.
The trade-off is that fixed rates protect you when interest rates rise, but if rates come crashing down you’re tied in and typically have a penalty to exit, so you could end up paying more than if you’d taken a tracker.
The type of mortgage also affects how quickly a change takes effect. If money markets expect the base rate to fall in the next four weeks, swap rates generally reduce before the actual Bank of England meeting, and we often see mortgage rates come down before the Bank acts. The same works in reverse: if money markets think the base rate is going to increase, mortgage rates can rise before the base rate does. That’s why, for example, after Covid we saw mortgage rates increase before the base rate did.
People often make the mistake of thinking that a base rate cut means all fixed-rate pricing will soon come down. In reality, it’s already been baked in.
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How do rising rates affect new build property versus existing homes?
Rising interest rates affect new builds differently from existing homes in three main ways: lender criteria, market incentives, and valuation risk.
On lender criteria, mortgage lenders often apply tighter rules to new build properties and cap the maximum loan to value. You might need a 10% deposit instead of 5%. The reason is that when interest rates rise, the cost of borrowing across the economy rises. Developers typically build with borrowed money, usually commercial loans, which squeezes their profit margins. It can become unprofitable for them to continue building, or they need to push up the value of homes to make a profit. That’s why lenders can be touchy about the deposit. Rising rates put the brakes on the economy, and the value of homes can hold fast or even reduce.
When buying a new build, you’re paying a premium, just like when you buy a brand new car and it loses value as soon as you drive off the forecourt. Once you’ve got the front door keys, it’s no longer a new build and that premium starts to wane. If interest rates are rising and you’ve only got a small deposit, you could end up in negative equity, where the value of the property is lower than the balance on the mortgage.
On market incentives, when the market slows, developers have to offer more to get buyers through the door. In a rising rate environment, they’ll start offering stamp duty and deposit incentives, or upgrades to flooring, kitchens, bathrooms, and gardens, all things you get with a normal house that cost extra on a new build. So with rising interest rates you might get a better deal on a new build, because developers need that profit margin to continue to borrow and build homes.
The third area is valuation risk. With new builds there’s no track record of how long the property will last, the standard of workmanship, or the quality of build materials. How does a surveyor know it’s been built to the right standard? Meanwhile, if a house has been standing for 100 years, it’s probably going to stay there. With borrowing more expensive, fewer people can get the mortgage they need to buy new build properties, so surveyors can be quite conservative on valuation. They need to ensure the lender isn’t offering a loan against an asset that’s not worth it, but they also have a duty of care to you as a buyer. You don’t want to buy a home with a deposit you’ve spent years saving up, only to find two years later that the value of the property equals the balance of the mortgage. You’ve effectively lost your deposit. You’ve been paying your mortgage and you don’t have anything to show for it. It’s important to understand the mechanics of the economy to decide whether that risk is acceptable.
Are there opportunities for first-time buyers when rates rise?
Yes, and this is often overlooked because people panic. There are genuine opportunities for first-time buyers who are well-prepared, for three reasons: less competition, more motivated sellers, and potential price adjustments.
On competition, higher interest rates generally push some buyers out of the market as people get worried. The cost of servicing a mortgage rises, and wages don’t necessarily rise in line with interest rates, so fewer people can afford to buy. There are fewer buyers and less competition, but the same number of homes in the UK. Fewer bidding wars. This is what’s called ‘a buyer’s market’.
On motivated sellers, some people become overstretched and are desperate to sell. We saw this during the Liz Truss mini-budget. Interest rates spiked very quickly, and people who had taken out big mortgages when rates were very low suddenly found themselves facing extremely high rates. Some couldn’t afford the mortgage, needed to sell quickly, but found fewer buyers able to purchase the home.
On price adjustments, all of this means there’s more room to negotiate on an asking price. Increasing interest rates put downward pressure on house prices. It can vary across the country, but even a small reduction in the purchase price can have a big impact over the life of a mortgage. Even if you’re paying 0.5% or 1% more on the rate, if you get 5% off the value of the home, that’s 5% not gaining compound interest. That can work out better. When we had very high interest rates, it was actually the best opportunity first-time buyers had to buy a home in the last 15 years, but that fell on deaf ears because people get nervous.
House prices did take a dip and people sold at lower prices, but over the past 12 months mortgage rates have reduced and house prices are beginning to increase again.
The economics of this are simple: zig when everyone else is zagging. Don’t follow the herd, do the opposite, and generally it works out well. Seek advice before you do, but that’s the opportunity.
How do higher interest rates affect my monthly mortgage payment?
It depends on the actual loan amount, how much the rate increases, and your mortgage term. Even small rate changes can make a big difference to what you pay each month, and more importantly, they affect how quickly you eat into the overall amount you’re trying to repay. The bigger the loan and the longer the term, the more negative the effect.
When you’re thinking about buying a home, you need to stress-test your budget. It’s not just whether you can afford the mortgage now, but what happens if interest rates rise by 2%, 3%, or 4%, because that may happen. You want to ensure you’re not in a position where you can’t afford to live in the property any more.
This is difficult, because house prices are high and it’s hard for first-time buyers to afford a home. Saving the deposit is a challenge, but you need to understand your position if rates did rise by 4%. For years people thought that couldn’t happen, but after the pandemic mortgage rates were as low as 1%, and within 18 months they were as high as 6%. It can happen.
How much less can I borrow compared to when rates were lower?
Rate changes don’t necessarily affect your maximum borrowing capacity by as much as you would think. That sounds odd, because a higher interest rate means a more expensive mortgage payment. But lenders stress-test mortgages when you apply, and they’re assessing you against a much higher bar than you might realise. What you can borrow isn’t affected much.
If mortgage lenders hadn’t stress-tested so severely, when interest rates spiked there would have been a big house price reduction, because more people wouldn’t have been able to afford their mortgages. They would all have been selling into a depressed market at the same time, with fewer buyers.
We didn’t see that. The housing market has been incredibly resilient despite energy shocks, the mini-budget, and high inflation. House prices didn’t fall much because lenders did such severe stress tests in a low interest rate environment to protect against exactly that scenario.
Will rising rates price me out of the market?
Not necessarily. It depends on how much rates rise by, what happens to house prices as a result, and your own circumstances: are you at risk of losing your job, and do you have other debts that make it harder to get a mortgage? Flexibility matters too. You might not be able to afford a four-bed detached house any more, but you might still get a three-bed semi or a two-bed terrace.
People worry about being priced out, but it’s often overstated. Interest rate rises don’t happen in isolation. The economy might be strong and wages rising, in which case higher earnings can improve your borrowing capacity and offset higher rates. Or we might have an inflation problem, in which case the cause of the rate rise determines whether it actually prices you out.
For example, from 2001 to 2007 we had a reasonably high Bank of England base rate and mortgage rates, but house prices were rocketing up. That’s because the economy was rebounding and growing at a strong pace. Even though mortgage rates were high, people kept buying houses because their wages were rising. In the past few years, though, interest rates rose because inflation was out of control. So what’s happening in the economy is what will impact you.
How do I recalculate my budget when rates increase?
If you’re worried about rates increasing, the first step is to understand the actual impact, then re-run your numbers against a higher rate. We don’t tend to see huge swings in the space of a few months. It can happen, but it’s not very common.
The questions to ask are: could I still borrow enough, how much will it cost me, and can I actually afford that? A good broker will already have done this stress-testing. They will have set your maximum budget by taking your current situation into account and looking at what happens if interest rates rise. Those are two very different calculations. One is the theoretical maximum mortgage from a lender. The other is the realistic maximum when you take everything we’ve spoken about into account. That second one is your real maximum.
For reassurance, you can update your Agreement in Principle. Do you still pass the affordability test at a higher rate? Do you still pass the lender’s credit scoring? Go through your budget again and look at how much headroom you have. Would you still be able to live life? There’s no point buying a home if you can’t do anything afterwards.
You could also consider increasing your deposit. It’s not easy to magic up 5% of a house price from nowhere, but you might decide to wait a while and save up a bit more to take the edge off. Or you could downsize your target property to something within a more comfortable budget, so if interest rates continue to rise, you’ll still be able to afford it. There are a few options.
We’ve covered a lot here – do you have any final thoughts?
First-time buyers are vƒery mindful of interest rates today because they’ve seen how volatile they can be. They know there can be an impact on house prices, mortgages, and people’s jobs. It’s good that they now recognise this. If you’re forewarned, you’re forearmed. When people aren’t aware and rates rise, they panic, get emotional, and don’t always make the best decisions.
Rising interest rates have, to an extent, been a good thing for first-time buyers. They’ve not been impacted directly by mortgage rates, but it has given them the insight to take this seriously and properly stress-test their budgets. They now seek proper advice on this, because there’s a lot they may not understand or find confusing. We can also ensure you’re protected. It’s not just about getting the mortgage today, it’s about ensuring you can stay in that house for the next 10, 20, or 30 years.
Key Takeaways:
- Rising interest rates, which refer to either the Bank of England’s base rate or mortgage rates, make borrowing more expensive across the board and are often used by the Bank of England to control high inflation.
- Fixed-rate mortgage pricing is based on SONIA swap rates, which are market predictions for the average future base rate over the mortgage term, and are not directly correlated with the current base rate.
- First-time buyers do not receive inherently worse interest rates, but they often end up paying higher rates because their smaller deposits (e.g., 5% or 10%) are the biggest factor influencing the interest rate.
- Rising interest rates can create a buyer’s market for prepared first-time buyers, leading to less competition, more motivated sellers, and potential room to negotiate on the purchase price.
- When preparing to buy a home, it is crucial to stress-test your budget against potential interest rate rises of 2%, 3%, or 4% to ensure you can afford the mortgage payments over the entire term.
RATES CAN FALL AS WELL AS RISE!
YOUR HOME MAY BE REPOSSESSED IF YOU DO NOT KEEP UP WITH YOUR MORTGAGE REPAYMENTS.